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The Little Quirk of Vol and Weekend Decay by Dan Passarelli

by contributor on 03-28-2011 11:09 AM

 

In trading, the thing that separates the men from the boys (or women from girls, if you will) are the details. The little quirks in pricing models and other analyses and calculations that not everyone knows about. These subtle nuances can cause the naïve to take it on the chin every now and then, while clever traders clean up.

 

One such quirk centers around the observation of implied volatility towards the end of the trading week. Implied volatility is calculated by taking option values and loading them into a pricing model with all the other relevant data to get the calculated volatility value of current market prices for options.

 

But what a lot of option traders don’t appreciate is that time decay kind of gums up the works for this calculation. Options lose value by the amount of their theta each day. But theta doesn’t come out of the option price on the closing bell each day. Professional traders have been around the block. They know theta is coming. So they move the day in their models ahead sometime during the trading day (i.e., before the end of the day) to get ahead of the game. In fact, towards the end of the week, they generally start taking time out of their models more aggressively because they need to take out a total of three days of decay to account for the weekend. Often, by the end of the day Friday, they have moved their models ahead three full days to reflect Monday’s theoretical prices. 

 

What does this have to do with implied volatility? Your model that calculates implied volatility does not know that traders have moved their days ahead. It only knows that options have gotten cheaper. Therefore, it yields a calculation of a lower implied option volatility. I would venture to say that traders and investors looking at a calculated implied volatility number (that they have not calculated themselves) dropping on a Friday may be missing something in the eqution: the importance and impact of three days of additional time decay.

 

 

dan@markettaker.com

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Comments
by Administrator on 03-29-2011 10:33 AM
Options

Funny you mention this.  I used to do this every Friday, concentrating on the front two months.  By 10:00am I was looking at Saturday prices and sometime after noon I was looking at Sunday's. The last hour I was looking at Monday's theoreticals.  Time decay is usually like watching paint dry, but you're right, just looking at Implied Vol's might not give you the whole picture.

Marty

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by stocksplit2000 on 03-29-2011 08:00 PM
Options

Another quirk is how one individual can lower the implied volatilities on options with wide bid ask spreads.  Its near the end of any trading day and the bid ask spread of multiple strikes is very wide for a stock.  A trader lowers the ask price by 10 cents.  The market maker electronically lowers the price another 10 cents.  The investor keeps lowering the price until there is no longer an automatic electronic adjustment by the market maker.  Now the bid ask spread on multiple strike prices may be reduced from multiple dollars to only 50 cents.  Now one individual has effectively reduced the printed implied volatility for the next day.

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by Administrator on 03-30-2011 10:42 AM
Options

Hello @stocksplit2000.

 

You're right in two areas.  The bid-ask spread with options at the end of the trading day tends to widen a little.  Why?  Marketmakers will tell you that many times during the trading day your option order to buy or sell has them hedging with the underlying shares.  If you send in an order with 30 seconds left in the trading day they might not be able to hedge with stock, forcing them into carrying overnight risk.  If the hedge is to buy or sell other options, will an order from you with 10 seconds left to trade give me the time to hedge with other options?

 

But back to implied volatility.  If an option is 2.00 bid, offered at 2.10, most option software takes the mid-point (2.05) and computes the implied volatility from that level.  If an investor offers the option for sale at 2.06 and nothing trades, the new mid-point is 2.03.  So nothing has traded but the implied volatility (with the option "at" 2.03 rather than 2.05) has dropped. 

 

Dan's blog fills in one piece of the puzzle as to why it "appears" that Volatility is dropping on a Friday, when Time Decay may be a major contributor.

 

Thanks for your comment. 

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About the Author
  • Mr. Bittman is the author of two books, Options for the Stock Investor, (McGraw-Hill, 1996), and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors, and he has presented several custom courses throughout the U.S., Europe, South America and Southeast Asia. In 1980 Mr. Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993, he was a Commodity Options Member of the Chicago Board of Trade where he traded options on financial futures and agricultural futures. Mr. Bittman received a BA, magna cum laude, from Amherst College in 1972 and an MBA from Harvard University in 1974. In addition to his responsibilities at The Options Institute, Mr. Bittman is also a member of the faculty of The Illinois Institute of Technology, where he teaches in the masters level Financial Markets and Trading Program.
  • Mr. Kearney began his long association with the CBOE when he became an independent Market Maker in early 1981. Mr. Kearney traded options full time on the trading floor until 1992 and periodically thereafter until 1996. In early 1992 he became a founding partner and Registered Options Principal of a brokerage firm based in Chicago, a member firm of the CBOE. Mr. Kearney’s responsibilities included development and implementation of hedging and trading strategies using listed options for their institutional clients as well as their retail investors. Mr. Kearney is the co-author of Understanding LEAPS®, published by McGraw-Hill, September 2002. He has been a regular contributor to many news services including Reuters, Derivatives Week, BARRON’S, CNBC, Bloomberg, Group W, The CBS Radio Network, FORTUNE, Ticker Magazine, Stock Futures and Options, BBC TV and Radio, NPR, and others. Mr. Kearney served on various committees at the CBOE, including the Arbitration Committee from 1984 to 1996. Prior to joining the CBOE Mr. Kearney was a marketing director for NCR Corporation. Mr. Kearney is a graduate of St. Mary’s University (MN), BS, 1971, and pursued his MBA at Lake Forest Graduate School of Management. In 2006 he completed a 3-year SII/SIA program at the Wharton School of the University of Pennsylvania.
  • Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Peter has spoken to thousands of investors across North America the past few years including over 200 webinars for the CBOE and member firms on trading options. He can also be seen each week on CBOE-TV with his show, Strategy of the Week. In addition to his responsibilities at the Options Institute, Peter serves as an Instructor for the Options Industry Council – an organization representing the options industry in the U.S. Prior to working at the Options Institute, Peter was a highly successful market maker for many years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management at the Options Institute.
  • Russell Rhoads, CFA, is an instructor with the Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management, Caldwell & Orkin Investment Counsel, TradeLink Securities and Millenium Management. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies. Since joining the Options Institute he authored Option Spread Trading: A Comprehensive Guide to Strategies and Tactics which was released in January 2011 and recently finished work on Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes which was published in August 2011. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois – Chicago and acts as an instructor for the Options Industry Council. He is a double graduate of the University of Memphis with a BBA ('92) and an MS ('94) in Finance and also received a Master's Certificate in Financial Engineering from the Illinois Institute of Technology in 2003.
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